Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Saturday, May 13, 2017

The Qualified Small Business Stock Exemption

Let’s say
that you are going to start your own company. You talk to me about different
ways to organize:

(1)Sole proprietor – you wake up in the
morning, get in your car and go out there and shake hands. There is no
paperwork to file, unless you want to get a separate tax ID number. You and
your proprietorship are alter-egos. If it gets sued, you get sued.

(2)Limited liability company – you stick
that proprietorship in a single-member LLC, writing a check to your attorney
and secretary of state for the privilege. You gain little to nothing tax-wise,
but you may have helped your attorney (and yourself) if you ever get sued.

(3)Form a corporation - a corporation is
the old-fashioned way to limit your liability. Once again there is a check to
your attorney and secretary of state. Corporations have been out there long
before LLCs walked the land.

You then have to make a decision as
to the tax flavor of your corporation:

a.The “C” corporation – think Krogers,
Proctor & Gamble and Macy’s. The C is a default for the big boys – and many
non-bigs. There are some goodies here if you are into tax-free reorganizations,
spin-offs and fancy whatnot.

Problem is that the C pays its own
tax. You as the shareholder then pay tax a second time when you take money out
(think a dividend) from the C. This is
not an issue when there are a million shareholders. It may be an issue when it
is just you.

b.The “S” corporation – geared more to
the closely-held crowd. The S (normally) does not pay tax. Its income is instead
included on your personal tax return. Own 65% of an S and you will pay tax on
65% of its income, along with your own W-2, interest, dividends and other
income.

This makes your personal return
somewhat a motley, as it will combine personal, investment and business income
into one. Don’t be surprised if you are considered big-bucks by the
business-illiterate crowd.

The S has been
the go-to corporate choice for family-owned corporations since I have been in
practice. A key reason is avoiding that double-tax.

But you can
avoid the double tax by taking out all profits through salaries, right?

There is a
nerdy issue here, but let’s say you are right.

Who cares
then?

You will.
When you sell your company.

Think about
it. You spend years building a business. You are now age 65. You sell it for
crazy money. The corporation pays tax. It distributes whatever cash it has left-over
to you.

You pay
taxes again.

And you
vividly see the tax viciousness of the C corporation.

How many
times are you going to flog this horse? Apple is a multinational corporation
with a quarter of a trillion dollars in the bank. Your corporate office is your
dining room.

The C stinks
on the way out.

Except ….

Let’s talk Section
1202, which serves as a relief valve for many C corporation shareholders when
they sell.

You are
hosed on the first round of tax. That tax is on the corporation and Section
1202 will not touch it.

But it will
touch the second round, which is the tax on you personally.

The idea is
that a percentage of the gain will be excluded if you meet all the
requirements.

What is the
percentage?

Nowadays it
is 100%. It has bounced around in prior years, however.

That 100% exclusion
gets you back to S corporation territory. Sort of.

So what are the
requirements?

There are several:

(1)You have to be a noncorporate
shareholder. Apple is not invited to this soiree.

(2)You have owned the stock from day one
… that is, when stock was issued (with minimal exceptions, such as a gift).

(3)The company can be only so big. Since
big is described as $50 million, you can squeeze a good-sized business in there.
BTW, this limit applies when you receive the stock, not when you sell it.

(4)The corporation and you consent to
have Section 1202 apply.

(5)You have owned the stock for at least
5 years.

(6)Only certain active trades or
businesses qualify.

Here are
trades or businesses that will not qualify under requirement (5):

(1)A hotel, motel, restaurant or similar
company.

(2)A farm.

(3)A bank, financing, leasing or similar
company.

(4)Anything where depletion is involved.

(5)A service business, such as health,
law, actuarial science or accounting.

A CPA firm
cannot qualify as a Section 1202, for example.

Then there is
a limit on the excludable gain. The maximum exclusion is the greater of:

(1)$10 million or

(2)10 times your basis in the stock

Frankly, I
do not see a lot of C’s – except maybe legacy C’s – anymore, so it appears that
Section 1202 has been insufficient to sway many advisors, at least those outside
Silicon Valley.

To be fair, however,
this Code section has a manic history. It appears and disappears, its percentages
change on a whim, and its neck-snapping interaction with the alternative
minimum tax have soured many practitioners. I am one of them.

I can give
you a list of reasons why. Here are two:

(1)You and I start the company.

(2)I buy your stock when you retire.

(3)I sell the company.

I get
Section 1202 treatment on my original stock but not on the stock I purchased
from you.

Here is a
second:

(1)You and I start the company.

(2)You and I sell the company for $30
million.

We can exclude
$20 million, meaning we are back to ye-old-double-tax with the remaining $10
million.

Heck with
that. Make it an S corporation and we get a break on all our stock.

What could
make me change my mind?

Lower the C
corporation tax rate from 35%.

Trump has
mentioned 15%, although that sounds a bit low.

But it would
mean that the corporate rate would be meaningfully lower than the individual rate.
Remember that an S pays tax at an individual rate. That fact alone would make
me consider a C over an S.

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.